Do Your Due Diligence (DD)

Contributor: Tim Hartley

You make your own success. You answer to you. You are the only one responsible for your decisions. Do not follow what anyone says blindly.

The stock market is a crazy place and lately, it seems like the Wild West. In a way, it sort of is. That is okay. A new era has begun as new retail investors are entering, and have entered, the marketplace. Financial freedom is being sought by many. Therefore, doing your own DD is important. Knowing the details behind why you are buying is important.

What is DD?

DD is short for Due Diligence. Due Diligence is taking reasonable steps to satisfy a legal requirement, especially in buying or selling something. It is also a comprehensive appraisal of a business undertaken by a prospective buyer, especially to establish its assets and liabilities and evaluate its commercial potential.

You want to do your DD on a stock before buying. How deep you go is up to you; however, I refer you back to the opening statement that you and only you are responsible for your decisions. Invest at your own risk.

There are some key points you want to consider when performing your due diligence. Some of these points include company capitalization, revenue, valuations, competitors, management, press releases, risks, and even social appeal. This last one can cause you to run for the hills or dive in. The decision is totally up to you and the risk is all on you how you go about handling it.

This article is to help you lay a solid foundation and apply fundamental analysis to your stock selection process.

Investing time to perform DD on a stock before making a purchase allows you to be better informed before making a decision that aligns with your overall investment strategy and plan. We discussed the importance of having a plan in a previous Blog Post: Failing to Plan is Planning to Fail.

Following the below points will help you with your DD:

Fundamental analysis: This considers a company’s fundamentals. The fundamentals will include knowing the management team, reviewing the financial results, reading press releases, and even anticipating how these varying factors will change the outcome for the company’s industry.

1) Value of a company

Look at the company’s market capitalization. This process will provide you with how large or small the company is. This is attained by calculating the total dollar market value of its outstanding shares.

The market capitalization says a lot about the stock’s potential volatility, how vast the ownership might be, and the possible size of the company’s end markets. During your journey, you will find that large-cap and mega-cap companies will typically have income streams that are steady and less volatile. Mid-cap and small-cap companies may only serve single verticals or areas of the market; therefore, there may be more fluctuation in the stock price and earnings. 

You’ve just begun your DD journey, so it is best not to make any yes or no decisions regarding the stock. Simply focus on acquiring any information that will allow you to make the decision on whether you wish to move forward with the stock.  When you start analyzing revenue and profit statistics, the information you have gathered about the company’s market capitalization will give you some perspective.

2) Revenue and margin trends

When you begin looking at the financial numbers related to the company you are researching, it would be best to start with the revenue, profit, and margin trends. Look up the revenue and net income trends for the past two years at a financial news site like the ones below: https://mediablog.prnewswire.com/2020/07/15/9-unique-finance-news-sites-that-are-worth-investing-your-time-in/.  You can search for in-depth company information using the company name or ticker symbol.

These sites provide historical charts for a company’s price fluctuation. You will also notice that they provide both the price-to-sales (P/S) ratio and the price-to-earnings (P/E) ratio. Identify any trends that have occurred recently in both sets of figures. Note whether growth is steady or variable. Also look for any major shifts up or down (i.e., more than 50% in a rolling 52 weeks).

Reviewing profit margins to see if they are generally rising, falling, or remaining the same is important. By going to the company’s website, you can find specific information regarding profit margins and searching the investor relations section for their financial statements. The information gleaned from this process will be more useful in the next point.

3) Competition

Once you have an idea of the size of the company and how much revenue it earns, it is time to size up the industries it operates in and its competitors. Compare the margins of two or three competitors. Every company has partially defined its competitors. Just by looking at the major competitors in each line of the company’s business (if there is more than one), you may be able to determine how big the end markets are for its products.

Typically, you will find information about a company’s competitors on most major stock research sites. On these sites, you will gain a better understanding of what the company does, identify gaps, and be able to determine whether they are positioned better in the marketplace than their competitors.

4) Looking at value

You’ve come this far. Great job! It may be a lot of work; however, building a portfolio in which you understand what you’re buying is essential. This is where the DD gets exciting. Numbers and value come into play. Review the price/earnings to growth (PEG) ratio for the company you are interested in and its competitors. Make a note of any large discrepancies in valuations between the company and its competitors. If you find yourself interested in another stock during your research just know that is completely normal. That happens a lot and is another reason why DD is so important. Write down the company so you can come back to it. You should continue your DD on the original company to ensure it is fully vetted.

P/E ratios allow you to form a baseline for determining valuations. Keep in mind that earnings can and will most likely have some volatility; no matter the company, valuations based on trailing earnings or current estimates are a solid measurement yardstick that allows immediate similarity to extensive market multiples and/or direct competitors.

By now, you’ll have an idea as to whether this stock is a “growth stock” or a “value stock,” and how profitable the company is. It’s in your best interest to analyze a few years (if possible) of net earnings figures; via this calculation, you can detect anomalies that may throw off the numbers by a large one-time correction or charge.

You should also utilize the price-to-book (P/B) ratio, the enterprise multiple, and the price-to-sales (or revenue) ratio. These multiples emphasize the valuation of the company as it relates to its debt, annual revenues, and the balance sheet. Because ranges in these values differ from industry to industry, reviewing the same figures for some competitors or peers is a key step. Finally, the PEG ratio brings into account the expectations for future earnings growth and how it compares to the current earnings multiple. Typically, stocks with a Price/Earnings to Growth ratio close to 1 are valued fairly.

5) Management and ownership

There are a few questions you will want to find answers to while performing due diligence on a stock:

a) Is the company still run by its founders?

b) Has management and the Board of Directors rotated new faces frequently?
Company age is a significant component here, as newer companies will typically have more of the founding members on board. Examining the consolidated bios of top managers to find out the breadth of experiences they have is important. Check the company’s website or its Securities and Exchange Commission (SEC) filings.

c) Are the founders and managers holding a high proportion of shares?

d) What amount of the float is held by institutions?
The percentage of institutional ownership provides how much analyst coverage the company is receiving, and also factors influencing trade volumes. Larger volumes of personal ownership by top managers should be seen as a positive, and low ownership is a potential red flag.  Always remember that they work for the shareholders. Higher ownership of shares by the founders and institutions tends to result in shareholders being served better than when people running the company do not have a stake in the performance of the stock.

6) Risks

This part is essential. You’ll hear people say “invest at your own risk” or “this isn’t financial advice,” and it’s because it’s true. There is always a risk with investing no matter what it is in. That is why it’s important to take the appropriate steps to understand the market, what you’re investing in, why you’re investing, and be okay with it if you lose. No one is going to tell you that you can or can’t invest your money or which stock you have to invest your money in. That decision is up to you and only you. 

Know that there are risks at the industry and company level. No one can predict the future; however, arming yourself with knowledge will help you stay ahead of the game. There will be outside factors that no one predicts. For example, the COVID-19 pandemic has changed the world for the past 16 months. No one saw that coming, except maybe your crazy Uncle Mike who says he saw it coming, but still wasn’t prepared. It’s why we are here, so when the next life-changing event happens, you/we will be better prepared. You’ll never be able to time the market correctly. Stay up to date on legal and regulatory matters by watching and reading the news. Set alerts through Google Alerts https://support.google.com/websearch/answer/4815696?hl=en on industries and topics you are looking to invest in. Stay on top of the decisions that management is making that lead to an increase/decrease in the company’s revenues.

Taking these steps will help empower you to do your own due diligence to become a better investor. Does it stink/suck/blow (whatever your terminology)? Yes, but you’ll be happy you did it when you’re sitting on the beach, mountains, river, valley, peak, moon, wherever you envision yourself 20, 30, 50 years from now.

As you progress in your investing journey, there will be lots of companies that come and go. Your time is valuable so don’t be afraid to toss some ideas in the garbage. There are so many companies to invest in that if you have a plan and do your due diligence then you’re better off in the long run.

Happy investing!